Credit Rating Agencies in the focus in Europe

Credit rating agencies (CRAs) are major players in today’s financial markets, with rating actions having a direct impact on the actions of investors, borrowers, issuers and governments. For example, a corporate downgrade can have consequences on the capital a bank must hold and a downgrade of sovereign debt makes a country’s borrowing more expensive. Despite the adoption of European legislation on credit rating agencies in 2009 and 2010, recent developments in the context of the euro debt crisis have shown our

existing regulatory framework is not good enough. So, today the Commission has put forward proposals to toughen that framework further and deal with outstanding weaknesses.

Internal Market Commissioner Michel Barnier said: “Ratings have a direct impact on the markets and the wider economy and thus on the prosperity of European citizens. They are not just simple opinions. And rating agencies have made serious mistakes in the past. I have also been surprised by the timings of some sovereign ratings – for example ratings

announced in the middle of negotiations on an international aid programme for a
country. We can’t let ratings increase market volatility further. My first
objective is to reduce the over-reliance on ratings, while at the same time
improving the quality of the rating process.Credit rating agencies should follow stricter rules, be more transparent about their ratings and be held accountable for their mistakes. I also want to see increased competition in this sector.”

Four main goals of the proposed draft Directive and draft Regulation

1. To ensure that financial institutions do not blindly rely only on credit ratings for their investments.

Ratings currently have a quasi-institutional role. We need to reduce our reliance on them. Our proposals in July 2011 on the Capital Requirements Directive IV reduce the number of references to external ratings and require financial institutions to do their own due diligence. Today, we are making similar changes with regard to rules relating to fund managers, in a complementary draft directive. And this will be completed by changes to rules on insurance next year. A general obligation for investors to do their own assessment is also included in today’s proposal.

In addition, more and better information underlying the ratings would need to be disclosed by CRAs and by the rated entities themselves, so that professional investors will be better informed in order to make their own judgments. For example, CRAs would have to communicate their ratings to the European Securities and Markets Authority (ESMA), which would make sure that all available ratings on the market for a debt instrument are published under a European Rating Index (EURIX), freely available to investors.

At the same time, credit rating agencies will have to consult issuers and investors on any intended changes to their rating methodologies. Such changes would have to be communicated to ESMA which would check that applicable rules on form and due process have been respected.

2. More transparent and more frequent sovereign debt ratings.

Member States would be rated more frequently (every six months rather than 12 months) and investors and Member States would be informed of the underlying facts and assumptions on each rating. To avoid market disruption, sovereign ratings should only be published after the close of business and at least one hour before the opening of trading venues in the EU. The possible suspension of sovereign ratings is a complex issue which we believe merits further consideration.

3. More diversity and stricter independence of credit rating agencies to eliminate conflicts of interest.

Issuers would have to rotate every three years between the agencies that rate them. In addition, two ratings from two different rating agencies would be required for complex structured finance instruments and a big shareholder of a credit rating agency should not simultaneously be a big shareholder in another credit rating agency.

4. To make CRAs more accountable for the ratings they provide.

A CRA should be liable in case it infringes, intentionally or withgross negligence, the CRA Regulation, thereby causing damage to an investor having relied on the rating that followed such infringement. Such investors should bring their civil liability claims before national courts. The burden of proof would rest on the credit rating agency.

Background

The EU Regulation on Credit Rating Agencies (CRA), (in force since December 2010), was part of Europe’s response to the commitments made by the G20 at the November 2008 Washington summit. This Regulation was amended in May 2011, to adapt the Regulation to the creation of ESMA.

The existing CRA Regulations focus on registration, conduct of business and supervision of CRAs:

(1) registration: in order to be registered, a CRA must fulfill a number of obligations on the conduct of its business (see (2)) intended to ensure the independence and integrity of the rating process and to enhance the quality of the ratings issued. The European

Securities and Markets Authority (ESMA) is entrusted since July 2011 with the
responsibility for registering CRAs in the EU; 28 CRAs (of which some belong to
the same group) are now registered with ESMA.

(2) conduct of business: the existing Regulation requires CRAs to avoid conflicts of interests (for example, a rating analyst employed by a CRA should not rate an entity in which he/she has an ownership interest), to ensure the quality of ratings (for example, requiring the ongoing monitoring of credit ratings) and rating methodologies (which must be, inter alia, rigorous and systematic) and a high level of transparency (for example, every year, CRAs should publish a Transparency Report).

(3) supervision: since July 2011, ESMA exercises exclusive supervisory powers over credit rating agencies registered in the EU and has comprehensive investigative powers including the possibility to demand any document or data, to summon and hear persons, to conduct on-site inspections and to impose administrative sanctions, fines and periodic penalty payments. This centralises and simplifies the supervision of CRAs at European

level. Centralised supervision ensures a single point of contact for registered CRAs, significant efficiency gains due to a shorter and less complicated registration and supervisory process and a more consistent application of the rules for CRAs. CRAs are at present the only financial institutions which are directly supervised by a European supervisory authority.

EU rules would apply to ratings of public entities within the EU but also outside the EU provided that the sovereign ratings are issued by a CRA registered in the EU.

The proposals now pass to the European Parliament and the Council (Member States) for negotiation and adoption.